1. Technical Field
The present invention relates to a system and method for evaluating collateralized debt obligations. More particularly, the present invention relates to a system and method of modeling scenario default or loss rates for evaluation of collateralized debt obligation transactions.
2. Description of the Background Art
The goal of structured finance is to allow lenders to make loans and structure the deals to free themselves from concerns over the creditworthiness of the borrower. One approach is the collateralized debt obligation, sometimes known as a CDO. Collateralized debt obligations are financial instruments that transfer the risk associated with a portfolio of assets to one or more investors. A cash collateralized debt obligation is a simple example. A special purpose entity is created, and various physical assets are transferred to it. These assets may include corporate or sovereign bonds, asset or mortgage backed securities or loans. Investors can then buy shares in the special purpose entity, providing them with return based on the performance of the basket of assets.
The advent of credit derivatives technology has made collateralized debt obligations more powerful. Whereas the special purpose entity in the cash collateralized debt obligation owns the physical assets, a synthetic collateralized debt obligation allows the special purpose entity to instead write credit default swap contracts. Generally, a credit default swap is an agreement between a buyer and seller. The buyer makes periodic payments to the seller. In return, if the referenced asset defaults, the seller makes a contingency payment to the buyer. The special purpose entity in a synthetic collateralized debt obligation may enter into dozens or hundreds of such credit default swap contracts.
Investors may be able to purchase shares of collateralized debt obligation tranches. Each tranche is a slice of the collateralized debt obligation's liability structure, and is paid off from the most senior to the most subordinate. For example, consider a collateralized debt obligation with ten tranches, each covering one tenth of the collateralized debt obligation. If the collateralized debt obligation loses 25% of its value, the seven most senior tranches will be completely paid. The eighth tranche will receive the remainder, 50% of what they could have earned, and the last two tranches will receive nothing. Each tranche is liable for losses above its attachment point, but not liable for losses above its detachment point. The collateralized debt obligation sustained losses that were above the detachment point of the two most subordinate tranches, so they received nothing, but were not liable for more than their share. The loss was halfway between the eighth tranche's attachment and detachment points, so it lost half of its potential value.
Synthetic collateralized debt obligation squared transactions enjoy more leverage than similarly rated synthetic collateralized debt obligations. A collateralized debt obligation squared is a collateralized debt obligation of collateralized debt obligations. The referenced collateralized debt obligations are bespoke, meaning that only one tranche is sold (other tranches may be held onto by a dealer). The collateralized debt obligation squared may reference 5-15 bespoke collateralized debt obligations, each of which references between 100 and 200 corporate names. The collateralized debt obligation squared is referred to as the parent collateralized debt obligation and the referenced collateralized debt obligations are referred to as underlying, or inner collateralized debt obligations. Many corporate names will be referenced by multiple bespoke collateralized debt obligations, often with 20-30% overlap between the bespoke collateralized debt obligations. The collateralized debt obligation squared may reference asset backed securities and other physical assets along with the bespoke collateralized debt obligations.
Structured finance continues to drive innovations in collateralized debt obligation technology. One example is the nth to default basket. Instead of writing a credit default swap where the seller pays the buyer when a single entity defaults, the nth to default basket is where the credit default swap references a number of entities (typically three to five), and the seller only has to pay the buyer once N entities have defaulted.
Prior CDO evaluation tools did not have the capability of rating these and other types of complex CDO transactions. Also, the accuracy of prior CDO evaluation tools suffered because of their assumption of a fixed recovery.
Thus, there is a need in the art for a system that can evaluate and model complex CDO transactions, including, but not limited to, equity default swaps (EDS), transactions involving assets with counterparty risk or forward start date, transactions in which assets are sold short, and transactions mixing corporate and small to medium-enterprise (SME) assets, etc. There is also a need for a tool that can more accurately assess the risk associated with CDO transactions.